Thursday, December 24, 2009

There is an interesting discussion sparked by Nick Rowe over at Worthwhile Canadian Initiative about financial black holes. Here and here.

FINANCIAL BLACK HOLES

Nick Rowe asks: Like physics, modern macroeconomic theory predicts the possibility of "black holes"…. If the economy gets too close to a black hole, it can't escape, and is sucked into a deflationary death-spiral. If nominal interest rates are at or near zero, and so at their lower bound, any deficiency of aggregate demand causes increased deflation, which in turn causes increased expected deflation, which in turn causes higher real interest rates, which in turn reduce aggregate demand, which in turn causes increased deflation...and so on. The price level and real output should both fall to vanishing point. Money in a black hole should have infinite value, yet nobody will buy anything with it….

So where are they? Why can't we see them? We sure have sailed our macroeconomic spaceships close enough to the boundaries of predicted black holes plenty of times. Why didn't any economy ever get sucked into one, and collapse into an infinitely valuable pinpoint?

A reader, Doc Merlin, comments :There is no such thing as a deflationary spiral. I have never ever seen it happen, never watched it, never seen it talked about in history. However, we have seen multiple times, INFLATIONARY death spirals…..Deflation is its own cure, because as prices drop, people will naturally want to consume more.

My own take, I can think of 4 variables which can help prevent the prevalence of black holes1. growing population2. growing productivity3. growing trade4. constant influx of new technology or products

An economy with high indebtedness, that cannot be paid for due to a lack of all 4, can probably experience a so-called financial black hole. In other words, my take on it is that we have so far avoided any instances of deflationary spirals because the world has always been growing somehow somewhere. And now, due to the gains from globalization, countries that may have otherwise experienced a slowing down of points 1 or 2, may compensate for it by an increase of point 3. Also, because globalization has increased the economies of scale for a lot of market innovations, it has enabled point 4 to remain constant.

However, there can be no escaping a market saturation, once a hitherto unmarketed-to geoeconomic area has been fully integrated to the global economy, and eventually trade growth will slow. So too, as a country’s population attains some affluence and occupational specialization, family rearing takes a back seat and even population growth slows down. Hence, the constant source of economic growth that we can expect going into the future, both at the business and at the macro level, will be to increase productivity or to introduce new technology or new products. These do not always come cheap. Debt, therefore, becomes more common among firms, and tolerance for larger portions of it become the norm.

DEBT

As debt becomes accepted as a necessary growth booster in the commercial arena, so too its prevalence become natural in the consumer arena. If businesses can borrow in anticipation of earning the cash to pay for it, why can’t an individual too borrow, if he believes the investment outlets available to him will enable to him to earn the necessary cash to pay it off.

So what we have is an economy, one that might be experiencing a stagnant population growth, a slowing productivity growth (due to constant misallocation of resources to endeavours that turn out to be counter-productive) but experiencing an increasing indebtedness among its population. I need not recount here how the increasing tolerance for debt plus "irrational exuberance" became strong factors in causing the credit crisis.

Now how can an economy pay for its collective debt obligations when the time comes, when there is a lack of growth in any of the 4 areas? This is where modern monetary policy theory comes in, to induce firms to invest (or induce households to purchase housing and durables)

Nick Rowe (talking about Keynes): Keynes is not sure whether an economy can escape the black hole of a deflationary spiral. If it does escape, it can only escape via the effects of an increase in M/P. And it will be more likely to escape if M/P increases due to a rising numerator M than a falling denominator P. Because falling P may create expectations of further deflation, which would further reduce aggregate demand.

COSTS OF DOING BUSINESS

Well and good if the increase in money supply does the job and avoids the debt deflationary spiral. However, this purely monetary theory does not consider a relatively more modern occurrence – the existence of hedge funds and other investment pools. These funds exist solely to arbitrage away any inefficiencies that are introduced to the market, both by the market itself, and by the government. So if money supply is increasing, it is actually creating an imbalance in the economy. It makes whatever scarce resources there are to become even more expensive. And hedge fund managers, being the arbitrage machines they are, try to profit by buying whatever resources they can identify that would have stable anticipated demand. These are therefore bid up more than they should.

So what happens to the business, the households, the economic actors who are meant to revive the economy via the increase of productivity or the introduction of new technology or new products? Their costs of production rise. As if it were not already risky to embark on costly new business endeavours, via a rising debt, in an economy with stagnating populations and saturated markets, you now have to do it in an environment where your cost of inputs may have been bid up beyond what it is could be profitable to turn up a finished product.

Thus, a focus on reviving the economy, and on preventing a deflationary spiral, via a monetary easing, has ended up introducing a new complication for the players necessary to turn the economy around. It has ended up spoiling the conditions necessary to spur more active market activities.

What happens then if no one is left to try to increase productivity or introduce new products and technologies? You go back to the possibility of a financial black hole.

That’s why I’m with Mark Thoma on this. Fiscal policy is a better policy alternative than monetary policy. Nick Rowe himself doesn't seem to side for more use of monetary policy (though he argues, correctly in my opinion, that it is not useless). But support should be going more towards helping build the market by focusing investment on industry-specific concerns, not on quantitative easing that goes nowhere and just increases business complexity or everyone. help industry rebuild itself. That’s what China is doing more of, and Western economies are well-advised to do the same.

5 comments:

"So if money supply is increasing, it is actually creating an imbalance in the economy. It makes whatever scarce resources there are to become even more expensive."

Let me see if I understand what you are saying. We are starting from an equilibrium. The creation of new money disturbs it and creates arbitrage opportunities, which the arbitrageurs take advantage of to move to a new equilibrium where scarce resources have not only higher prices, but higher prices relative to other goods and services. Right?

This new equilibrium is, however, inferior to the original one. Right?

If that is right, I have a question. Since we have a fiat currency, with no intrinsic value, why don't both equilibria have the same relative prices?

Merry Christmas to you too! In both equilibrium cases, scarce resources remain constant. So expanding fiat currency makes the scarce resource artificially more expensive, relative to other goods. Because these scarce resources have a stable demand, oil for instance, because it is a necessary component in many activities, then many investors could 'rationally expect' that holders of oil will be able to profitably sell it to the market when they take delivery.

However, because hedge funds who are merely looking for arbitrage profit enter into the bidding along with bidders who are actually end users, they make pricing for the scarce resource artificially more expensive. This serves to crowd out the smaller businesses who may not have the economies of scale to be able to earn back what it will cost them to buy the scarce input. Think of it like scalpers crowding out potential concert goers with lower income

The current economic environment is tough, with the total debts of the US economy amounting to 60 trillion dollars (both private and public) the interest payments alone of 3 trillion a year prove to be a massive drag on economic activity.

Generating inflation is now on the highmark of the agenda of the Wall Street elite, yet doing it in a deflationary environment is difficult. To find out how inflation can be brought into the world and the implications for geopolitics please read http://financialmarkets2007.blogspot.com/

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"Conventional approaches, unconventional conclusions" on the global finance and economic issues of the day. Rogue Econ has been a banker and financial consultant in several countries. Welcome to my blog.